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CP Investment Help CenterFor Victims of the Stock Market,
 Here Are a Few Simple Lessons

By Ali Jaffery

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 Sept. 2002 - Twelve months ago, investors hoped they had seen the worst of the bear market. They hadn't.

 

U.S. stock-focused mutual funds on average have declined 19.9% in the 12 months through this week and fallen 30.3% since stocks' peak in early 2000.

 

So what have mutual-fund investors learned as the market turned from bad to worse? For one thing, many have found out whether they were really cut out for the risk entailed in owning stocks.

 

A decade-long bull market left some unprepared when gains turned into losses. Indeed, in July, investors pulled $52 billion -- a record dollar amount -- from their stock funds.

 

While kernels of investing wisdom today can't undo the bear market's losses, some lessons are worth recounting after a tumultuous year. Here are three:

 

Chasing hot investments is a good way to get burned.

 

Today's most-popular investment category often ends up being tomorrow's disaster. Science and technology funds, for example, more than quintupled from 1995 to 2000, then lost about 75% of their value and virtually all of the increase.

 

For a while after the technology-stock meltdown, energy stocks got hot, only to fall apart amid accounting scandals and the bankruptcy of Enron Corp. The investors who got in near the top of any of these moves seemed like they were betting on a sure thing, but now much of their investments have probably vanished.

 

A similarly disappointing outcome awaited investors who put tens of billions of dollars into the then-hot growth-stock mutual funds in early 2000. After those funds sagged, some of the same investors then rushed to small-cap funds in 2001, only to see them lose money in 2002.

 

Today, real-estate investment trusts and bond portfolios are performing well. But putting too much money in any hot investment approach will almost always get you burned.

 

Follow the three D's of portfolio management.

 

If real-estate investing depends on the three L's of location, location, location, then building a portfolio that can better withstand stormy weather depends on the three D's: diversification, diversification, diversification.

This isn't new advice -- mutual-fund companies have been preaching about it for decades -- but investors often want to ride all the winners they have during a bull market. Making protective moves through diversification often gets forgotten.

 

In 2001, people were starting to take heed of diversification again, but weren't taking it far enough. They spread out their bets to different types of stock funds, but that didn't protect them against the losses this year as nearly all classes of stocks have gone down at once.

 

Six of the seven U.S. sector-fund averages and all nine stock-style averages tracked by research firm Morningstar Inc. have fallen during 2002.

 

Bond funds, on the other hand, have rallied this year to gains of around 5% or 10%. As a result, an investor who split money between stocks and bonds in a balanced fund would be down only 11.5% in 2002 and about 16% since the stock-market peak, according to Lipper Inc.

 

[Graph]

 

So while not preventing all losses, such a diversified portfolio blunted the impact of the bear market.

 

Know when to sell them.

 

A buy-and-hold strategy makes the most sense for long-term investors, but that's not to say you should forever hold every mutual fund in your portfolio. Diversification moves can prompt some prudent selling. So can changes in circumstances such as the departure of a fund's manager or adjustments in an investor's time horizon before needing to cash in the account. Sometimes it's just a good idea to get rid of a bad fund.

 

Investors shouldn't be surprised if they encounter resistance when wanting to get rid of fund shares. Given a chance, mutual-fund companies and the brokers and planners that sell their products often will advise investors to hang on, trumpeting the short-term returns of their best portfolios. But while investors should never sell fund shares hastily, they should realize that even those top fund performers are likely -- and sometimes even more likely -- to suffer a future slump.

 

Most investors don't like to sell their losers because it's like admitting defeat, but some funds still deserve to be sold..
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